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Greek Letters of Finance

Greek Letters of Finance

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Hedging of Financial Derivatives and PortfolioInsurance
Gasper Godson Mwanga
African Institute for Mathematical Sciences6, Melrose Road, 7945 Muizenberg, Cape TownSouth Africa.e-mail: gasper@aims.ac.za, gmlangwe@yahoo.co.ukSupervisor :
Prof. J. C. Ndogmo
Department of MathematicalUniversity of Western CapePrivate Bag X17, 7535 Bellville, CapetownSouth AfricaJune 23, 2005
 
Contents
1.1 Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.2 Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21.3 Derivative security. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31.3.1 Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31.3.2 Forwards and Futures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41.3.3 Swaps. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41.4 Important Formulae. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.1 Naked and Covered Position. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62.2 Stop-Loss Strategy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72.3 Delta Hedging. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82.3.1 Hedging Performance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102.3.2 Delta of Forward Contract. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112.4 Delta of European Calls and Puts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112.4.1 Delta of Other European Options. . . . . . . . . . . . . . . . . . . . . . . . . 122.5 Theta. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132.6 Gamma Hedging. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
 
CONTENTS
ii
2.6.1 Making a Portfolio Gamma-Neutral. . . . . . . . . . . . . . . . . . . . . . . 152.6.2 Calculation of Gamma. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162.6.3 Relationship between ∆, Θ & Γ. . . . . . . . . . . . . . . . . . . . . . . . . . 162.7 Rho (
). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182.8 Vega (
V
). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192.8.1 Calculation of Vega. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212.9 Scenario Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
3.1 Preliminary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233.2 Using Index Options for Portfolio Insurance. . . . . . . . . . . . . . . . . . . . . . . 243.3 Creating Options Synthetically. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253.3.1 Use of the Trading of Portfolio. . . . . . . . . . . . . . . . . . . . . . . . . . 253.3.2 Use of Index Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

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